How I Bought the Internet — and You Can Too

February 19, 2014 in Analysis
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A few months ago my firm bought the Internet. Let me explain: When people think about the Internet, they imagine an enormous, decentralized (key word), spiderweblike network of millions of servers and hundreds of millions of business and personal computers, all loosely connected to one another. That image makes a lot of sense; after all, the Internet was created by the Defense Advanced Research Projects Agency (Darpa) to make sure the military forces and other branches of the government could communicate in case of nuclear war. This was my image of the Internet too — but then I read Tubes: A Journey to the Center of the Internet by Andrew Blum, and this naive notion was completely shattered.

Blum, a journalist who used to write about architecture, went on a quest to discover what the Internet is after a squirrel chewed through a cable at his home and severed his connection. To his surprise (and to mine as well), he found that the Internet is a lot more intimate than the common conception; it is really a network of networks located in a few dozen buildings globally that hold most of those decentralized servers. In Tubes, Blum goes on about a company that owns most of these buildings — Equinix.

Before Equinix, if Yahoo wanted a direct connection to Comcast’s customers, it would put a server in the telecommunications provider’s data center. Because Comcast would not want the fiber of competitors, such as Charter Communications, coming into its data center, if Yahoo also wanted to connect to Charter it would have to put another server in that company’s data center. This was a very cumbersome and inefficient way to connect.

Enter Equinix. The Redwood City, California–based company creates what have come to be called network-neutral data centers. It invites all telecom providers to bring their fiber into its data centers (actually, they’re more like communication centers — more on that later) and promises that when they come there will be lots of customers (the Yahoos) waiting for them to connect with.

But Equinix faced the quintessential catch-22, a dilemma not unlike inviting a lot of boys to a party with the lure that there will be a ton of beautiful girls there and at the same time telling the girls that it will be packed with handsome boys. As you begin assembling the party, however, the room is empty. Equinix would make the Wizard of Oz proud — it pulled the party off. Today the company has more than 100 data centers in over 33 markets and is by far the largest provider of network-neutral data centers globally.

Its business model is very straightforward: An Equinix data center is like a hotel that has several hundred rooms (in this case, 8-by-8-foot cages). Companies like Yahoo, Facebook and Google and telecoms like AT&T, Charter and Comcast — the who’s who of the Internet — rent cages from Equinix for their servers and switches. Now Yahoo can connect to all the telecoms directly by linking its servers through fiber directly to their servers just a few dozen feet away.

But it gets more interesting. Yahoo discovers that a lot of traffic goes between its website and Google’s and Facebook’s, so it runs fiber from its servers directly to their servers, which are just a few cages down. Magic then happens — the network effect takes a quantum leap. If you are Dropbox or Amazon and looking to hook up with telecoms and other who’s whos of the Internet, your options in most markets are limited to Equinix or … Equinix.

The Equinix economic model is simple: It charges customers somewhere between $1,500 and $1,800 a month to rent the cage, and interconnection fees add up to another few hundred dollars; plus, the company passes through energy costs directly to its customers.

Equinix’s buildings are usually described as data centers, but I don’t think that does justice to the strength of its competitive advantage. Data centers are usually a commodity type of service — a secure building with a very good fire-extinguishing system and reliable backup generators, hosting server farms for a few or perhaps hundreds of customers — and on the surface Equinix fits well into this description.

However, if you and I raised somewhere between $20 million and $50 million (we could probably even borrow at very low rates, as the loan would be secured by real estate), we could hire an engineering firm to design and build a state-of-the-art data center for us. Barriers to entry here are very low — price ends up being a decisive factor. Unless you are a low-cost provider — a position very hard to achieve — you will earn back barely your cost of capital.

But Equinix doesn’t provide garden-variety data centers, because it has pricing power. If you and I were to build our data center right next to Equinix’s and try to woo its customers away by giving them 80 percent off for the first 100 years, they still would not come. That’s because when you are in the business of connecting, you don’t want to be a contrarian, you want to follow the crowd (I know this sounds weird coming from a contrarian). Network effect is an extremely powerful competitive advantage — this is why we have only a few credit card networks, one eBay, and only a few commodities exchanges.

According to Blum, in the markets where Equinix dominates — which is almost all of them — its competitors typically offer just one tenth the number of cross-connections. Even if you and I found some naive takers for our 80 percent-off offer and pointed out that they would pay considerably less per square foot, they would retort that networking is not about price per square foot, it’s about price per connection and who you are connected with. Our customers would end up paying more per connection. And on top of that, they’d still have to spend hundreds of thousands of dollars on servers and other communications equipment and ongoing maintenance while getting just a fraction of the cross-connections they’d be receiving with Equinix.

The speed of the Internet is bounded by the speed of light — which is quite fast, some 300,000 kilometers a second. By the time you say “one Mississippi,” light has traveled around the globe 7.5 times. So you’d think physical distances matter very little when it comes to the Internet, but they do. Milliseconds add up fast, and having your communication centers distributed globally will only become a more important competitive advantage over time. Impatience and instant gratification are one of the largest U.S. exports — consumers want things now. According to Amazon, every 100-millisecond (one tenth of a second) delay costs the company 1 percent of sales — that is, hundreds of millions of dollars. Equinix helps companies cut down on those milliseconds.

Growth of mobile and the global Internet will directly drive demand for Equinix cages. From a valuation perspective, its stock is trading at 46 times 2014 earnings — not cheap for a value investor whose stocks on average sport single-digit or low-teens multiples. But surface analysis doesn’t capture the wonderful economics of Equinix’s business and its true valuation. No, I am not going for a price-to-eyeballs model here.

Equinix’s high growth obfuscates the true economics of its business. Once a data center is running at 90 percent capacity, it generates a return on equity of around 30 percent. However, you won’t see these returns by eyeing Equinix’s financials because, as demand keeps increasing, the company is building data centers worldwide and thus continuing to operate at a mid-70 percent utilization. Equinix is in the process of converting into a real estate investment trust; the sell side is convinced that the conversion will be approved, but even if it falls through it will cost the company only $1 or $2 of free cash flow per share. Equinix’s depreciation expense significantly exceeds its maintenance capital expenditures, and it is also spending a lot of money on upgrading its financial systems and on its REIT conversion — all this depresses its true earnings power. In our analysis, assuming only modest revenue growth over the next two years, rising utilization from mid-70 percent to low-80 percent produces $14 to $16 in free cash flow per share.

In addition to the bragging rights of having the Internet in your portfolio, Equinix brings a high recurrence of revenue, an insurmountable competitive advantage, a still-significant growth runway, and about a 4 percent dividend yield if the REIT conversion goes through. That’s a combination that’s hard to beat.

This article was originally published in Institutional Investor Magazine

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